July 06, 2006

Why is inflation bad?

Inflation appears to be back, with recent reports showing it higher than in recent years. Recent turmoil in the stock market, some say, is over this inflation scare. But why should we fear higher inflation? What’s so bad about it? These are the questions N.C. State University economist Mike Walden answers in today's Economic Perspective.

"I think one simple reason is higher inflation means that we have to get that much more out of our job to stay even," says Dr. Walden, a professor in the Department of Agricultural and Resource Economics. "In other words, if the inflation rate is 5 percent a year that means you’ve got to get a 5 percent pay raise just to keep pace with rising costs.

"From a business perspective, inflation eats into business profits. It … gives businesses a much more difficult time adjusting, for example, to international competition," he adds.

"On the investment front, inflation sort of clouds what we are getting from our investment returns. For example, let’s say you are earning 6 percent on an investment. If we had no inflation, that would be a very good return. But if inflation is 5 percent, that’s a very bad return, so you have to keep that in mind when you are looking at these investment alternatives.

"And then, last, inflation often leads to higher interest rates," Walden concludes, "and so anyone who wants to borrow money it’s going to be more expensive. So I think for these many, many reasons this is why economists tend to prefer lower inflation."